Strategy for Small Fish

Microsoft, Wal-Mart, and eBay provide ecosystems in which other companies thrive or fail. But what are effective strategies for a small fish in a big pond? An excerpt from The Keystone Advantage by HBS professor Marco Iansiti and Roy Levien.

by Marco Iansiti and Roy Levien

Editor's Note— The art of business today seems to be the ability to influence resources your company doesn't own—resources such as the production scheduling of manufacturing partners, the packaging requirements of distribution partners, and the development of technical standards your products must incorporate.

Welcome to the age of business interdependence, say HBS professor Marco Iansiti and collaborator Roy Levien, authors of the new HBSP book The Keystone Advantage: What the New Dynamics of Business Ecosystems Mean for Strategy, Innovation, and Sustainability.

Think of the business environment as a series of ecosystems, they urge, with "keystone" companies such as Microsoft and Wal-Mart providing for the health of all who do business with them. What are the best strategies for companies living in these ecosystems? This excerpt focuses on strategies for niche players.

The essence of a niche strategy is to achieve specialization by taking explicit advantage of the opportunities provided by the ecosystem while avoiding the kinds of traps that challenge firms in such environments. Our observation of a variety of niche strategies in action highlights a few critical components.

Value creation

The first driver of an effective niche strategy is value creation.

Specialize in unique capabilities. An effective niche strategy creates value by selecting a specialization that is truly different and whose differences are sustainable over time. A classic mistake made by a variety of new ventures during the venture capital boom of the late 1990s was selecting areas that had no staying power, such as Web calendars or Web-dispatched limousine services. Over time, it was inevitable that these new niches would merge with existing ones. The services are now broadly offered, but the firms that started developing them have ceased to exist as independent entities. In those cases in which the skills and capabilities that characterized new ecosystem domains were distinct enough to justify a truly focused strategy (for example, personal financial accounting or customer relationship management software), these strategies have endured for many years and enabled the growth of large and successful firms (such as Intuit and Siebel Systems).

A well-executed niche strategy, because of its focus, will exhibit strong defenses against a keystone and dominator trying to expand. Intuit is again a strong example here, with the continued success of its Quicken application against Microsoft Money. The key is finding a large enough market that requires specialized capabilities.

Leverage other capabilities from keystones. Effective niche players recognize that they are no longer bound by the constraints of vertical integration. As with IDe or deNovis, they create system solutions by combining their specialized assets with complementary products and platforms provided by other niche players and keystones. They embrace the opportunity to be lightweight and focused and leverage the tools, technologies, services, and products available through the ecosystem.

In doing this, niche strategies trade off risk with productivity. Strong economies can often be found by niche players by leveraging a single platform—for example, NVIDIA can optimize its designs for yields on TSMC's production lines. If a strong, trustworthy keystone is present in the niche player's ecosystem, there may be no apparent reason for the niche player to connect to multiple platforms. However, because of the risk of keystone collapse and keystone hold-up, niche players may want to diversify and invest in connecting with multiple hubs. As we discuss in some detail later, the crucial factor in figuring out which of these strategies to pursue is developing an understanding of the necessary "coupling strength," which defines the switching costs between keystones.

Sustain innovation. Whether dealing with one or multiple keystones, the heart of technology strategy for a niche player is to continually innovate by integrating technology available from the ecosystem to sharpen the niche offering that it is crafting. It is important to examine technological threats coming from the edge, and to leverage the ecosystem in crafting response strategies. This lets focused players develop specific solutions and concentrate on integrating these with key specific assets inside the firm. Intuit enabled its application, Quicken, for the Web by integrating technology components provided by Microsoft.

This implies a fundamental change in technology strategy models. In a vertically integrated setting, a company needs to develop into a massive organization and cover a broad variety of business areas in order to scale and survive. This makes scaling the company very challenging and requires a massive amount of capital. Additionally, it makes the company highly vulnerable to technological changes and other types of shocks. In a distributed business ecosystem, a firm can scale more easily and respond to shocks by leveraging capabilities provided by others.

Healthy business ecosystems will support a large number of niche firms for long, sustained periods of time. In the software industry, a large number of niche players have endured for many years, constantly generating a variety of product innovations. Despite the contraction caused by the crash of 2000 and the recession that followed, the ecosystem is still enabling thousands of different firms to survive.

Value sharing and risk management

How can a niche player influence the way that value is shared in an ecosystem? How can it protect itself against the risks of hold-up or keystone obsolescence? One of the most critical factors is the coupling strength of the implied interactions. Tight coupling (or high coupling strength) implies that a given niche player needs to develop highly specific internal assets to leverage the assets provided by a third party. NVIDIA needs to spend a significant amount of time optimizing its designs to TSMC's manufacturing process. This in turn implies that once committed to a given partner, the cost of switching is very high. Loosely coupled interactions instead imply minimal asset specificity and enable a niche player to easily switch from one relationship to another.

Tight coupling: Manage risk and dependencies. Tradition holds that tightly coupled relationships are by nature more efficient; for example, close collaboration between customers and suppliers is usually favored in existing management theories. However, tightly coupled models also have many disadvantages.

First, the tighter the coupling between organizations, the higher the risk of hold-up and the more power that platforms have over niche players. Thus, niche firms are much more at risk if a keystone decides to dominate its environment. Additionally, if the coupling strength is high, niche firms are more vulnerable to significant changes in technology and business models, which explains the many challenges and incumbent failures highlighted in a variety of research.19

A common failure of niche players is to bind too tightly to a keystone, which increases the power of the keystone over the niche player and can ultimately compromise the health of the entire ecosystem.

Loose coupling: Embrace mobility and flexibility. The heart of operating strategy for a niche player is to leverage the broad-based efficiencies offered by connecting up with several players in an ecosystem, while managing the dependencies that are created. This kind of behavior is made much easier by the emergence of loose coupling for the computing ecosystem. The essence of the argument is that less invasive, "minimalist" interfaces between organizations and technologies have the great advantage of minimizing technological risk and hold-up.

The emergence of loose coupling has enormous implications for niche firms because it means that an organization is no longer as threatened by the replacement of one technology with another. Because interfaces in loosely coupled systems are lightweight and noninvasive, firms can change much more easily in response to massive shifts in the technological environment. In essence, this means that they can much more easily "plug in" to a different way of doing business. Examples are provided by NVIDIA easily cutting across generations of semiconductor technology, or by enterprise IT departments easily embracing the Web.

In the software industry, for example, we have witnessed how the emergence of loosely coupled interfaces has enabled the majority of application companies to leverage multiple platforms. The same is true in the semiconductor and retail industries. The reality is that loosely coupled interfaces such as XML are quite powerful, so that reasonably strong efficiencies can be achieved with little commitment of platform-specific assets. Niche players can connect to both TSMC and UMC, or to Wal-Mart and Target, or to Microsoft and Apple. They can exchange design rules and purchase orders, and can optimize supply chains across different systems.

Niche leverage: Power over keystones. Finally, the emergence of loosely coupled technology interfaces has another critical implication for niche firms. Because loose coupling enables mobility, niche firms acquire enormous collective negotiating power with respect to keystones. The same mobility that allows them to escape devastating technological transitions allows them to potentially "leave" a keystone that is trying to extract too much value from the system for itself or that is not creating a platform that enhances opportunities for value creation.

Niche players, in effect, can use this leverage to keep keystones honest and to prevent them from straying into becoming dominators. It is in fact in this sense that ecosystems compete: They compete with each other for mobile niche players. And it is precisely this competition that keeps ecosystems healthy: Without niche players who understand and exercise this leverage, ecosystems will be less healthy than they could be and may fall into sickness if their keystone loses sight of its role.

Innovation and niche evolution

Firms that pursue a focused niche strategy have an ultimate advantage in the creation of novelty. This is partly because a focused new idea can more closely correspond to a new firm than is possible in vertical or modular industry structures: Everything beyond the scope of the firm can be integrated from external sources, or, conversely, a new product or technology offered by the firm can be easily integrated into the existing ecosystems as an extension or addition to its capabilities.

Firms that actively seek out new terrain in this way have the further advantage that as they distinguish themselves in new domains they may create platforms and become keystones themselves. NVIDIA is a great example of this kind of pattern.

NVIDIA's emergent keystone strategy

NVIDIA has grown rapidly to become not only a vibrant niche player in the integrated circuit ecosystem, but also to serve in some ways as a keystone itself, supporting the development of firms in the adjacent hardware and software communities. By following a successful and focused niche strategy, NVIDIA built a firm foundation for the next step: the transformation of its niche into an ecosystem in its own right, with NVIDIA as its keystone.

NVIDIA's Select Builder program, for example, supports system builders for PCs, laptops, and workstations. NVIDIA also maintains reseller and distributor partnership programs for firms that promote the NVIDIA line of products.20 In addition, the firm supports an active NVIDIA Registered Developer program to provide software developers in sectors ranging from video games to engineering simulation with training, tools, and support for application development tailored to exploit the unique capabilities of NVIDIA graphics processors.21 NVIDIA provides a significant set of tools, libraries, and standard interfaces that enable its own ecosystem to be more effective. This sharing of assets with channel partners and applications developers makes NVIDIA a keystone in its own right, with a role that is likely to increase in significance over time.

Building the complexity of the ecosystem

Firms like NVIDIA play a crucial role in structuring the complexity of an ecosystem in ways that make it accessible and manageable. In effect, they represent rungs in a ladder of ascending complexity that facilitate the power of platform leveraging: Hardware manufacturers that build on the "NVIDIA platform" are not just leveraging NVIDIA's products; they are also leveraging those of TSMC. This "serial leveraging" enabled by firms such as NVIDIA that are both niche players (focused experts in a domain) and keystones (platform providers) is a critical source of the productivity and rapid advance in capabilities of their ecosystem. Such firms are woven into the fabric of the business ecosystem just as surely as the textile craftsmen and merchants and traders were woven into the textile business ecosystem in Datini's time.

Footnotes:

19. For example, see R. M. Henderson and K. B. Clark, "Architectural Innovation: The Reconfiguration of Existing Product Technologies and the Failure of Established Firms," Administrative Science Quarterly35 (1990): 9-30; and Clayton M. Christensen, The Innovator's Dilemma: When New Technologies Cause Great Firms to Fail (Boston: Harvard Business School Press, 1997).

About the author

Roy Levien is a principal at Aldaron and founder of Keystone Advantage LLC.

Excerpted with permission from Harvard Business School Press, The Keystone Advantage: What the New Dynamics of Business Ecosystems Mean for Strategy, Innovation, and Sustainability, by Marco Iansiti and Roy Levien. Copyright 2004, Harvard Business School Publishing Corporation. All rights reserved.